Chapter 10 MERGERS AND ACQUISITIONS Behavioral Corporate Finance by Hersh Shefrin
The Winner's Curse in M&A • Between 1991 and 2001, shareholders of acquiring firms lost $216 billion, thereby experiencing the winner's curse. • Disproportionate share traced to very large losses by a few acquirers during the period 1998 through 2001. • Many of the large loss acquirers had been active acquirers prior to their large loss acquisitions, and the market values of their firms had been increasing.
Optimistic, Overconfident Executives • Hubris hypothesis. • Excessively optimistic, overconfident CEOs • Are described as such in the press, and • Wait too long before exercising options. • More likely to have completed an acquisition. • Tendency compounded when firm is generating positive cash flow, but mitigated when board size less than 12.
Cash Flow • Financially constrained firms run by excessively optimistic, overconfident CEOs choose not to go to the capital markets in order to secure the funds needed to conduct an acquisition. • They act as if the market undervalues the equity and/or risky debt issued by their firm.
AOL Time Warner • In January 2000, America Online (AOL) announced its intention to acquire the media conglomerate Time Warner. • Goal was to create a distribution channel whereby Time Warner’s media products would be delivered via Internet broadband. • The purchase price, $165 billion in AOL stock, set an acquisition record.
Valuation • The combination of AOL and Time Warner occurred at the height of the technology stock bubble. • In January 2000, the market capitalization of AOL was $185.3 billion, over twice as large as the $83.7 billion market capitalization of Time Warner. • The market’s judgment of the overall merger was favorable, with the shareholders of Time Warner benefiting at the expense of the shareholders of AOL.
Steve CaseMarket Timing • Case judged that dot-com stocks, including AOL, were overpriced, and he sought to exploit the overpricing through market timing. • He expected that Internet stocks would collapse in the not too distant future, and sought to protect AOL shareholders by acquiring a more mature firm.
Gerald LevinTrusted Market Prices Gerald Levin trusted market prices. During a press conference to announce the merger Levin stated: Something profound is taking place. I believe in the present valuations. Their future cash flow is so significant, that is how you justify it.
Asset Writedown • In April 2002, AOL Time Warner wrote down $54 billion in goodwill, to reflect the decline in the value of the combined firm. • In the previous 12 months, the operating profit for most AOL Time Warner businesses experienced positive growth. • But its AOL business fell 30%.
Hubris • The adjective “hubris” has frequently been applied to Steve Case in the press. • The New York Times did not paint a flattering picture of the executives at Time Warner, stating: “If Case was guilty of hubris, then the Time Warner management team was guilty of ignorance and credulity, industry analysts and academics say.”
H-P and Compaq • In May 2002, H-P acquired Compaq Computer. • In 1999, H-P was involved in three broad business segments, two of which were in decline. • enterprise computing and services for businesses, losing to IBM. • personal computers (PCs), losing to Dell. • imaging and printing, • 118% of H-P's overall operating profits.
Proposed Merger • On July 19, 2001, Fiorina raised the merger issue with the other eight members of H-P’s board. • Only three expressed interest, most were resistant. • H-P director Sam Ginn raised doubts about becoming more deeply involved in the PC business. • Patricia Dunn noted that history has produced many unsuccessful technology mergers and asked what would make the odds of this one any better?
Three Questions Posed by Fiorina • Do you think the information-technology industry needs to consolidate and, if so, is it better to be a consolidator or a consolidatee? • How important is it to our strategic goals to be No. 1 or No. 2 in our chief product categories? • Can we achieve our strategic goals without something drastic?
Behavioral Issues • Did Carly Fiorina’s questions appeal to the directors’ natural tendency to be overconfident? • Did she frame the issue for them in a way that placed them in the domain of losses? • In speaking about drastic action, did she induce them to be risk-seeking?
Dismissal • In February 2005, The Wall Street Journal characterized H-P’s business services group as second-tier, relative to industry leader IBM, and noted that its computer division was losing its battle against Dell. • That month, H-P’s board dismissed Carly Fiorina as CEO of H-P, and named independent director Patricia Dunn as nonexecutive chair.